Sharpe Ratio Creator Criticizes Retirement Solutions

The mind behind the Sharpe ratio says the rule of thumb most financial advisors use to determine adequate withdrawal rates in retirement is “suboptimal,” Barry Ritholtz writes in Bloomberg.

William Sharpe, the Nobel laureate who devised the famous model for capital asset pricing and the reward-to-variability ratio, tells Ritholtz that the recommended 4% annual withdrawal rate doesn’t address the complexity of the decision.

The six sets of variables in determining what percentage to withdraw yearly are not particularly complicated on their own, according to Ritholtz, founder of Ritholtz Wealth Management. For example, the various mortality outcomes derived from actuarial tables produce many combinations when considering a couple over the course of 30 years, he writes.

But that has to be combined with the more than 100,000 possible outcomes for a stock and bond portfolio every year, according to Ritholtz.

Then there are thousands of possible inflation outcomes and how they impact purchasing power, the thousands of potential returns from Treasury Inflation Protected Securities tied to inflation, and the various incomes that couple could receive in retirement, he writes. Then there’s what Ritholtz calls the most subjective of variables: the utility of income.

To address the interaction between all the various matrixes, Sharpe has devised the so-called “retirement-income scenario matrix project,” Ritholtz writes.

Sharpe has made all of his work and data available free on his website at Stanford University, with the hope that financial engineering courses can eventually help financial advisors guide retirement investors toward more accurate choices when it comes to retirement income, according to Ritholtz.

The complexity of the challenge is great, but so is the need to resolve it, he writes.